Investors pursue a wide variety of investment strategies in order to balance the level of risk they find acceptable with their desire to maximize their returns. Leveraging a portfolio has the potential to magnify growth, but can also magnify losses. One way to leverage a portfolio is by using a margin account. Margin accounts are monitored to ensure that the equity remains above the maintenance margin. If the value of the account drops below the maintenance margin, the investor can add money or securities to the account in order to raise the value of the equity above the maintenance margin. If the portfolio suddenly declines in value, the investor may need to liquidate some assets quickly in order to sustain the maintenance margin. Consequently, it is easier to respond to market fluctuations if the assets are liquid, such as publicly traded securities, than if the leveraged assets are illiquid, such as, for example, hedge funds.
Despite the complications inherent in leveraging investments in hedge funds, investors still desire to do so. Investors want to combine the potential for increased gains afforded by leveraging assets with the professional investment management provided by hedge funds. Collateralized Fund Obligations (“CFO”) are one method which investors use to securitize investments in hedge funds. A CFO uses hedge funds as the collateral against which a variety of debt and equity securities are offered. Each of these securitizations has an asset manager who actively manages the dynamic asset allocation and makes coupon payments on the notes primarily through redemptions and liquidations.
A CFO, however, does not efficiently leverage the hedge funds. As a result of the illiquid nature of hedge funds, if the net asset value of the hedge funds drops, the investments cannot be liquidated quickly to increase the equity in the margin account. In order to decrease the likelihood of this happening, a higher maintenance margin must be maintained. Another disadvantage of CFOs is that some of the assets must be liquidated on a periodic basis in order to make the interest payments on the debt. As a result, the asset manager must regularly reassess the allocation of assets in order to determine which assets should be liquidated. This increases the management costs.
It remains challenging for investors to leverage investments in illiquid assets without experiencing the above-described disadvantages.